How to Make Budgets [Complete Steps with Examples]

How to Make Budgets [Complete Steps with Examples]

Budget, in short is a company’s annual financial plan. In long word, it is a set of formal (written) statements of management’s expectations regarding sales, expenses, production volume, and various financial transactions of the firm for the coming period. Budget is consists of pro forma statements about the company’s finances and operations. What steps needed to make a budget?

It is the company’s tool for both planning and control. At the beginning of the period, the budget is a plan or standard; and at the end of the period, it serves as a control device to help management measure the firm’s performance against the plan so that future performance may be improved.

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Through case examples, this post provides a sequenced step-by-step guide to set up a budget, since the sales stage until the cash budget, budgeted income statement and budgeted balance sheet. The discussion is started from the general structure of the budget. It’s a long-long page. For faster page-load, I splitted them into 11 (eleven) pages (each page contains one step – one type of budget.) Enjoy!

General Structure Of a Complete Set of Budget

A complete set of budget is classified broadly into two categories which are inter-related one to the other:

To take you through the actual steps, I make a company named “Lie Dharma Putra Company.” It is a manufacturer of a single product, as its annual budget is created for the year 2011. The company develops its budget on a quarterly basis. The example will highlight the variable cost–fixed cost breakdown throughout. Let’s start from the Sales Budget. Read on the next page (click page 2 at the bottom of this page).

Making the Sales Budget

The Sales Budget (some company may call it as “Sales Forecast” Or “Sales Projection”) is the starting point in preparing the operating budget, since estimated sales volume influences almost all other items appearing throughout the annual budget. The sales budget gives the quantity of each product expected to be sold. (For the Lie Dharma Putra Company, there is only one product. Of course, in a real company, most likely multiple products—that you can add lines of product row-by-row).

Basically, there are three ways of making estimates for the sales budget:

Make a statistical forecast on the basis of an analysis of general business conditions, market conditions, product growth curves, etc.

Make an internal estimate by collecting the opinions of executives and sales staff.

Analyze the various factors that affect sales revenue and then predict the future behavior of each of those factors.

After sales volume has been estimated, the sales budget is constructed by multiplying the estimated number of units by the expected unit price. Generally, the sales budget includes a computation of cash collections anticipated from credit sales, which will be used later for cash budgeting (see below example).

Example

Assume that of each quarter’s sales as follows:

70 percent is collected in the first quarter of the sale;

28 percent is collected in the following quarter; and

2 percent is uncollectible

So here is the “Sales Budget” come along with the “Schedule of Expected Cash Collection”:

The next step is constructing the “Production Budget”. Follow on the next page below.

Production Budget

After sales are budgeted, the production budget can be determined. The number of units expected to be manufactured to meet budgeted sales and inventory is set forth. The expected volume of production is determined by subtracting the estimated inventory at the beginning of the period from the sum of units to be sold plus desired ending inventory. See below example.

Example

Assume that ending inventory is 10 percent of the next quarter’s sales and that the ending inventory for the fourth quarter is 100 units. Using data from the “Sales Budget“, here is the “Production Budget”:

With the “Production Budget”, you can carry on the next process; constructing the “Direct Materials Budget”.

Direct Materials Budget

When the level of production has been computed, a direct materials budget is constructed to show how much material will be required and how much of it must be purchased to meet production requirements. The purchase will depend on both expected usage of materials and inventory levels.

The direct materials budget is usually accompanied by a computation of “Schedule of Expected Cash Disbursement (Payments)” for the purchased materials.

Example

Assume that ending inventory is 10 percent of the next quarter’s production needs; the ending materials inventory for the fourth quarter is 250 units; and 50 percent of each quarter’s purchases are paid in that quarter, with the remainder being paid in the following quarter. Also, 3 pounds of materials are needed per unit of product at a cost of $2 per pound.

Using the “Production Budget”, here are the “Direct Material Budget” and “Schedule of cash Disbursement (Payment)” comes look a like:

The next step is the “Direct Labor Budget.”

Direct Labor Budget

The production budget also provides the starting point for the preparation of the “Direct Labor Cost Budget”. The direct labor hours necessary to meet “Production Requirements” multiplied by the estimated hourly rate yields the total direct labor cost.

Example

Assume that 5 hours of labor are required per unit of product and that the hourly rate is $5. Here is the Direct Labor Cost Budget:

After this, you can continue to create the “Factory Overhead Budget.”

Factory Overhead Budget

The factory overhead budget is a schedule of all manufacturing costs other than direct materials and direct labor. Using the contribution approach to budgeting requires the development of a “Predetermined Overhead Rate” for the variable portion of the factory overhead. Later, in developing the “Cash Budget”, note that the “Depreciation” does not entails a cash outlay and therefore must be deducted from the “Total Factory Overhead” in computing cash disbursements for factory overhead.

Example

For the following factory overhead budget, assume that:

Total factory overhead is budgeted at $6,000 per quarter plus $2 per hour of direct labor.

Depreciation expenses are $3,250 per quarter.

All overhead costs involving cash outlays are paid in the quarter in which they are incurred.

The Factory Overhead Budget figure becomes as shown below:

The next step of the operating budget set is the “Ending Inventory Budget”.

To be able to construct the Cash Budget and the Pro forma Financial Statements, you need to construct the “Selling and Administrative Expense Budget” first.

Selling and Administrative Expense Budget

The selling and administrative expense budget lists the operating expenses involved in selling the products and in managing the business.

Example

Let’s say the variable selling and administrative expenses amount of $4 per unit of sale, including commissions, shipping, and supplies; expenses are paid in the same quarter in which they are incurred, with the exception of $1,200 in income tax, which is paid in the third quarter.

Referring to the Sales Budget, the “Selling and Administrative Expense Budget” become as follows:

Until this stage, now we have enough data to construct the 3 most essential set of a company’s budget: “Cash Budget“, “Pro forma (Budgeted) Income Statement,” and the “Budgeted Balance Sheet.”

Cash Budget

The cash budget is prepared in order to forecast the firm’s future financial needs. It is also a tool for cash planning and control.

Because the cash budget details the expected cash receipts and disbursements for a designated time period, it helps avoid the problem of either having idle cash on hand or suffering a cash shortage. However, if a cash shortage is experienced, the cash budget indicates whether the shortage is temporary or permanent, that is, whether short-term or long-term borrowing is needed.

The cash budget typically consists of four major sections:

The receipts section, which gives the beginning cash balance, cash collections from customers, and other receipts

The disbursements section, which shows all cash payments made, listed by purpose

The cash surplus or deficit section, which simply shows the difference between the cash receipts section and the cash disbursements section

The financing section, which provides a detailed account of the borrowings and repayments expected during the budget period

Example

Let’s assume the following:

The company desires to maintain a $5,000 minimum cash balance at the end of each quarter.

All borrowing and repayment must be in multiples of $500 at an interest rate of 10 percent per annum.

Interest is computed and paid as the principal is repaid. Borrowing takes place at the beginning and repayments at the end of each quarter.

The cash balance at the beginning of the first quarter is $10,000.

A sum of $24,300 is to be paid in the second quarter for machinery purchases.

Income tax of $4,000 is paid in the first quarter.

With these assumptions combined with the previous budgets that we have generated, the Cash Budget becomes as follows (please pay attention to the note below the budget figure):

Note:

Collection from customer – from the “Schedule of Expected Cash Collections“

Direct Materials – from the “Direct Material Budget“

Direct Materials – from the “Direct Labor Budget“

Factory Overhead – from the “Factory Overhead Budget“

Selling and Administrative – from the “Selling and Admin Expenses Budget“

Next, you can easily construct the “Pro forma (Budgeted) Income Statement“.

Pro forma (Budgeted) Income Statement

The budgeted income statement summarizes the various component projections of revenue (sales), costs and expenses that have been figured on the previous budgets for the budgeting period. For control purposes, the budget can be divided into quarters, for example, depending on the need.

Here is the “Budgeted (Pro forma) Income Statement” (Please attention on the notes):

Note:

Sales – from the “Sales Budget“

Variable Cost of Goods Sold – from the “Ending Inventory Budget“

Variable Selling and Administrative – from the “Selling and Admin Expense Budget“

Factory Overhead – from the “Factory Overhead Budget“

Selling and Administrative – from the “Selling and Admin Expense Budget“

Interest Expense – from the “Cash Budget“

On the next page is the final budget: “Pro forma (Budgeted) Balance Sheet“. Read on…

Pro Forma (Budgeted) Balance Sheet

The budgeted balance sheet is developed by beginning with the balance sheet for the year just ended (“Previous Year’s Balance Sheet“), in this example is for the year ended December 31, 2010, and adjusting it, using all the activities that are expected to take place during the budget period.

Here is the “Previous Year’s Balance Sheet“:

Some of the reasons why the budgeted balance sheet must be prepared are:

To disclose any potentially unfavorable financial conditions

To serve as a final check on the mathematical accuracy of all the other budgets

To help management perform a variety of ratio calculations

To highlight future resources and obligations

Here is the Budgeted Balance Sheet as below (please pay attention to the note below the figure):

Budgeting Beyond Basic

Well, that’s a detailed procedure for formulating a basic set of budgets. However, in practice a shortcut approach to budgeting is quite common and may be summarized as follows:

A pro forma income statement is developed using past percentage relationships between relevant expense and cost items and the firm’s sales. These percentages are then applied to the firm’s forecasted sales.

A pro forma balance sheet is estimated by determining the desired level of certain balance sheet items, then making additional financing conform to those desired figures.

The remaining items, thus, are estimated to make the balance sheet balance. There are two basic assumptions underlying this approach: (1) The firm’s past financial condition is an accurate predictor of its future condition; and (2) The value of certain variables such as cash, inventory, and accounts receivable can be forced to take on specified desired values. This version called “Percent-of-Sales Method”.

If I can manage my time, I will discuss the approach soon in the future. Some issues most probably arise after the completion of the budget. For example: What happened if the actual isn’t the same with the budget? How to make a weekly cash budget, what data would you need to have and how to make the budget (should you take it from the cash budget that you have made for quarterly basis)?. Let’s also include the weekly cash budget steps on the future post. Meanwhile, you may want to try to implement this.

Your extensive knowledge in accounting, finance, and tax are impressive. I really appreciate your generosity of sharing these knowledge. May I have the pdf version of this article and the budget sample sheet in excel format?

Many thanks for help , It was really nice and could you please send me ,how to budget the airlines operations , step by step guide in word and calculation of them in excel sheet.
Best regards,
Shah Aziz Ghawsi

Thanks for the info… Can you please tell me with what figure that you calculated the interest / loan repayment in the cash budget? The assumption stated that the borrowings must be in multiples of $500 and interest rate is 10%. Hpw did you also come about with the borrowing figure? And if the borrowing is $8500 why is it that the 10% interest rate is not $850? I am a bit confused in the financing section of the cash budget…Thanks in advance for your help/

Dear putra! how are you doing?
it is really very help ful. but i want further explanation on finance section of cash budget, specially what is meant by multiples of 500? where does 8500 come? if borrowing 8500, how interest at 10% annually could be 425?

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